Mutual Funds, ETFs, and Hedge Funds

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Mutual Funds, ETFs, and Hedge Funds

• Chapter 4

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Services of Investment Companies

• Administration and record keeping
• Diversification and divisibility
• Professional management
• Lower Transaction Costs

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Characteristics of Investment Companies

• Typically small minimum investments
• Assets are pooled together, so one client is
  affected by other client actions
• No special tax strategies possible
• Clients do not own the actual shares of stocks
  they are invested in
• Instead, they own shares of the fund that owns
  the underlying stocks

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Market Value CalculationNet Asset Value
Example Market Value 100 mil Number of Shares
10 mil NAV 100 / 10 10 / share Suppose
Market Value goes up to 112.5 mil, and the fund
expenses during that period were 0.1 mil. What
is the ending NAV? NAV (112.5 0.1) / 10
11.24 / share
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Types of Investment Organizations

• Managed Investment companies
• Open-end funds (mutual funds)
• Closed-end funds
• Other investment organizations
• ETFs (Exchange Traded Funds)
• Hedge Funds

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Open-end (Mutual Fund)

• Number of shares outstanding can vary from day to
  day.
• Buy back (redeem) shares or sell additional
  shares at the NAV. Need to hold cash reserve for
  redemptions.
• There may be a sales charge (load) when the fund
  sells the shares to customers.
• May charge a redemption fee when the customers
  sell their shares back by the fund.
• Fund can cap out and not accept new investors.
  Otherwise, the fund can continue to grow by
  issuing new shares.

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Mutual Fund Styles

• Money market
• Fixed Income
• Equity
• Balance Income
• Asset allocation
• Specialized sector (gold, financial)
• Style (Growth versus Value)
• Indexed

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Equity Mutual Funds Classes

• Income Funds High Dividend yield stocks.
• Growth Funds Forego dividend yield for capital
  gains. Invest in well-established firms.
• Aggressive Growth Seek maximum capital growth.

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Mutual Fund Fees

• Sales and Marketing Fees
• Front End Load Paid when shares are purchased.
• Load from 3 to approximately 8 of NAV
• Low-Load Up to 3
• No-Load No sales charge
• Be careful! Back-End Loads
• 5-6 fee on sale. Typically drops by say 1
  every year.
• 12b-1 Fees
• An alternative to a load to cover advertising
  marketing expenses. No-Load and Low-Load funds
  use these.
• Can deduct as much as 0.75 of assets annually to
  cover fund advertising marketing.

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Sales Marketing Fee Choice

• Some funds give you a choice as to how you want
  to pay your share of the expenses by offering
  alternatives called choices A, B or C.
• A Front-end load. No 12b-1 fees. No back-end
  load.
• B No Front-end load. Small 12b-1 fees. back-end
  load that decreases the longer you hold shares.
• C No Front-end load. Larger 12b-1 fees. Shorter
  back-end load penalty period.

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Management and Record Fees

• Management Fees
• Range is typically 0.20 to 1.00.
• Records Fees
• Can be as much as 0.25 of assets annually.

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Expense Ratio

• Total Annual Expenses include
• 12b-1 fees, Management fees, records fees
• Expense Ratio
• Total Annual Expenses/ Amt of Fund Assets
• Studies find that funds with lower expense ratios
  earn higher returns than those with higher
  expense ratios.

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Typical Feesfor US. Domestic Equity Fundsas of
2005
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Closed-End Funds

• Shares of the fund trades on the secondary market
• Fund does not usually offer additional shares or
  repurchase shares
• No need for cash reserve for liquidity needs.
• Market price is often different from (usually at
  a discount to) the NAV.

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Closed-End Fund Fees

• Management and Record fees can be charged within
  the fund
• Sales charges do not exist
• Commissions are charged to each purchase and
  sale, exactly like a stock transaction

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ETFs (Exchange Traded Funds)

• A Hybrid of open-end fund and the closed-end
  fund.
• Traded throughout the day, similar to the
  closed-end fund.
• Institutional investors can redeem shares for the
  underlying securities, or exchange the portfolio
  of stocks for the shares, similar to the open end
  mutual fund.
• Implication on premium/discount.
• Examples
• SPDR, DIAMOND, Qubes
• iShares track international indices
• Sector ETFs (energy, utilities, technology,
  industrials, transportation, etc.)

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ETFs (Exchange Traded Funds)

• Example
• Spiders
• One share 1/10 of price SP 500 index.
• Can create or delete by exchanging shares plus
  cash at the end of the day in units of 50,000
  shares and cost of 3,000. (fixed, not affected
  by number of units).

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Concerns Turnover Taxes

• Turnover Fraction of portfolio replaced each
  year.
• Mutual funds, CEFs, and ETFs have
  pass-through-status which means that taxes are
  paid only by the investor, not the mutual fund.
• To accomplish this, the fund must pass on all
  capital gains and dividends to the client.
• Not an issue if in a tax-deferred retirement
  account

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Hedge Funds

• Often off shore
• Typically only offered to qualified investors
• More risk allowed, and typically taken
• More flexible in their investments short
  positions, leverage, private placements
• Higher fees charged
• More frequent change in their composition
• Pure ones are market neutral

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Hedge Funds

• Dynamic investment
• Rarely buy-and-hold
• Fees reflect active management
• Information-driven trading
• Static risk analytics not appropriate

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Hedge Funds

• Long/Short Market Neutral Strategy
• CAPM
• Beta of the portfolio0.
• Fama-French 3-factor
• Small cap manager 50 long, 50 short in growth
  stocks so neutral regarding style risk.
• Growth style manager 50 long, 50 short in
  small cap stocks so neutral regarding size risk.

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Index Fund and Passive Equity Management

• Logic Market is fairly efficient. Too difficult
  to overcome 1 - 2 costs of running an active
  equity portfolio.
• Goal Dont try to beat the market, just equal
  it!
• Passive Features
• Portfolio is built without using technical or
  fundamental analysis.
• Buy Hold The securities are purchased and then
  held with only occasional re-balancing (reinvest
  dividends, a change in the index etc)

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Index Funds

• Passive portfolios that track an index and sell
  shares to investors are called Index Funds (Eg
  Vanguard 500 Index which tracks the SP 500.)
• Manager Performance Judged by how well he/she
  tracks the index or sector and by the costs
  generated to do so.

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Size of Indexing--- as of June 2003
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Index Fund Types

• 1. Full Replication Buy all stocks in the index
  in proportion to their weights in the index.
• 2. Sampling Buy the stocks with larger index
  weights hold a representative sample of the
  others.
• Benefit Relative to Full Replication Lower
  commissions (fewer stocks to purchase and to
  reinvest dividends).
• Drawback Relative to Full Replication Tracking
  Error.

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Evaluating Index Fund Manager Performance

• R-Square Measures how closely the fund is
  moving with the benchmark index
• This measures tracking, but not costs
• Tracking error Measures tracking and costs
• ? absolute value of (Rit Rmt), t 1 to T, or
• ? (Rit Rmt)2, t 1 to T

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Addition and Deletion Effects for Indexes

• Additions
• What to expect? Why?
• Deletions
• What to expect? Why?
• Empirical Evidence
• Chen, Noronha, and Singal (2004, Journal of
  Finance)

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Implication for Index Fund Investors

• NY Times (July 4, 2004)
• Barrons (April 3, 2006)
• Chen, Noronha and Singal (2006, FAJ)
• Compare losses to two popular indexes
• Investors in funds indexed to SP 500 lose up to
  0.10 per year
• Investors in funds indexed to the Russell 2000
  lose up to 1.84 per year
• Total loss Up to 5 billion
• Note Losses in the mutual fund scandal were
  estimated between 0.5 and 3 billion.

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Assignment

• Chapter 4 Problems
• 2, 3, 4, 6, 10, 11, 18